Crypto market crash: Recession concerns and UST causes market chaos

[metaworld114]

Bitcoin and the wider crypto makets suffered a severe sell-off on Monday. This article explores the external and internal factors that drove the price drop.

Digital asset markets dipped sharply on Monday with Bitcoin (BTC) dropping by nearly 10% in the past 24 hours. Some altcoins such as LUNA fell by as much as 25%. Internal and external factors contributed to the selling pressure.

Market Cap Top 10. Source: Bravenewcoin.com

External-Sell-offs in risk markets driven by recession fears

Parallel to the downswing in the crypto market, stocks also sold off heavily as macro investors across the board have opted to reduce their exposure to risk assets.

The S&P500 hit a new low for 2022 and is down ~3.2% in the last day while the Nasdaq composite is down ~4.3%. Big-ticket tech stocks like Tesla and Nvidia are down ~9% in the last day, while other major players like Meta, Alphabet, and Amazon also fell.

The correlation between Bitcoin and equity market indices has hit new highs in recent weeks. The 30-day Pearson correlation coefficient between the BTC price and the Nasdaq composite currently sits at 0.96, while for the S&P 500 it sits at 0.91. This implies that the price of Bitcoin and the US stock market index are almost moving in sync with each other.

 

Source: The Block data, CryptoCompare

 

Market momentum for speculative assets like equities has fallen away amid concerns that global inflation will continue to surge and economic growth will slow. Inflation in the USA, the world’s largest economy, hit a four-decade high of 8.5% in March 2022.

The US Federal Reserve raised interest rates by 0.5% in response and most forecasts predict more aggressive rate hikes are set to be introduced as the economy tangles with historically high inflation.

The central bank rate hikes will constrain capital and investment capability. This may slow down inflation but it will come at the cost of economic growth. The economy is being put under further strain because of the extended Russia/Ukraine conflict and China’s strict ongoing Covid-19 lockdowns.

The challenges faced by the US economy are mirrored in the EU, UK, New Zealand, Australia, and other OECD economies. Inflation has surged in these countries after extended periods of expansionary monetary policies and low interest rates led to the money supply ballooning.

These economies now face the possibility of stagflation, a situation where the inflation rate is high but economic growth is slow. Policymakers face a difficult challenge, sharp interest rate rises will reduce inflation but will negatively affect already stagnant growth and unemployment. Trying to gradually raise interest without affecting economic growth may be too conservative and could lead to inflation surging even higher.

Investors appear to have lost confidence in the Central Banks' ability to dig economies out of the stagflation and recession hole. They are pulling money away from risk markets and into safe, stable investments. Most investors expect markets will remain volatile and skewed towards the downside.

Internal-UST de-pegging causes market chaos

The price of the largest algorithmic stablecoin in crypto, UST, had a spectacular collapse on Monday. The shockwaves sent by the potential black swan have affected the rest of the crypto market and in particular assets associated with the UST ecosystem.

UST currently trades for ~US$0.74. It should be 1-for-1 with the US dollar and the value is extremely concerning for holders of the token who bought into an apparently stable asset. LUNA, the asset that supports UST as its collateral source, is down a staggering 53% in the last 24 hours. With more and more being minted to try and push UST back towards its peg, there may be further pain yet to come.

 

 

LUNA price in the last 24 hours: Source- Brave New Coin

 

 

UST price in the last 24 hours: Source- Brave New Coin

US Dollar Terra (UST) is an algorithmically pegged stablecoin that uses a mint-and-burn mechanism with LUNA and UST as its levers. LUNA is the native token of the Terra ecosystem. The protocol contracts and expands the supply of the two tokens to ensure UST maintains its 1-to-1 peg with the US dollar.

When the price of UST is below US$1, the supply of UST needs to be constricted to make up for reduced demand. Terra will then let arbitrageurs mint LUNA which can be swapped for UST worth US$1 even though the price of UST is less than 1 dollar. In this situation the supply of LUNA increases.

Fiat-backed stablecoins such as Tether (USDT) hold actual US dollars in reserve. It is more straightforward for a 1-to-1 fiat-backed stablecoin to return to its peg once it has dropped off its peg. If the price of UST drops because of a fall in demand, and the price of LUNA is falling at the same time, the amount of new LUNA that would need to be minted to maintain the peg will continue to rise. A death spiral can occur as more and more LUNA is printed to try and recapitalize UST.

An enormous amount of LUNA has been minted to try and help UST retain its peg. terra.smartstake.io

According to Twitter user @Route2FI, the disorder began on Sunday because of a UST sell-off on a decentralized exchange Curve. This led to rumors across markets and social media that led to further UST withdrawals on Anchor. The jitteriness lasted and there appears to have been a large scale run from UST.

Parallel to the bleak macroeconomic environment, which was already turning investors away from risky, volatile assets such as altcoins, the UST turmoil is further spooking investors.

UST and Luna were key projects that won during the crypto bull market and the DeFi 2.0 season. The failures of the project have affected the short-term sentiment surrounding DeFi infrastructure pieces like algorithmic stablecoins. Tokens that serve a similar purpose to LUNA (they also support stablecoins), Frax shares (FXS), and Spell Token (SPELL), are each down ~23% in the last 24 hours.

The systematic chaos caused by UST could have been expected. Terraform Labs has been expanding the presence of UST to chains outside of Terra in recent months. A non-profit, the Luna Foundation Guard (LFG), has been buying assets other than LUNA to build a protective layer for UST.

LFG bought a large amount of bitcoin (BTC) that could be dipped into if UST ever lost its peg. In interviews, Terraform Labs founder Do Kwon explained that BTC was chosen because it was a neutral, liquid asset that was held by users across various DeFi chains. An enormous amount of BTC was bought by the LFG, well over US$3 billion, and it made LFG one of the largest bitcoin holders on the planet holding a reported 80,394BTC.  www.btctalker.com

There were concerns raised over the LFG strategy. In a scenario where UST loses its peg, LFG may have to dump a large amount of BTC on the market to protect it. Terra was trying to anchor UST to the entire crypto market.

Today, LFG has announced that it has loaned $750M worth of BTC to OTC trading firms to help protect the UST peg but has also taken on a US$750 million UST loan to accumulate BTC as “market conditions normalize.” The loan amount in BTC is ~37,000.

According to LFG’s last tweet, referencing the loan. “Very little of the recent clip has been spent but is currently being used to buy $UST”.

Do Kwon, in his last tweet, tried to reassure investors “Deploying more capital - steady lads”.